Income tax: application of Division 13 of Part III and double tax agreements to permanent establishments

This Ruling deals with: (a) the application of Division 13 of Part III of the Income Tax Assessment Act 1936 ('ITAA 1936') in determining the income and expenditure of permanent establishments ('PEs'); and (b) the attribution of profits to PEs under Australia's double tax agreements (DTAs) which are schedules to the International Tax Agreements Act 1953 ('Agreements Act').

The specific provisions analysed are subsections 136AE(4) to (7) in Division 13 [F1] and the business profits articles in DTAs (usually Article 7 in Australia's recent DTAs). [F2] Together these provisions are referred to as Australia's PE attribution rules.

This Ruling focuses on attribution issues where the relevant parts of a multinational enterprise (MNE) are structured as a single legal entity carrying on business operations through a PE. The results and methodologies involved are similar to cases applying Australia's transfer pricing rules to international dealings between separate but associated legal entities which have been analysed in Taxation Rulings TR 94/14, TR 97/20 and TR 98/11. There are, however, differences between the two groups of rules that may produce different outcomes in the PE setting.

The OECD has provided guidance on the matters covered in the Ruling in its 1994 Report entitled Attribution of Income to Permanent Establishments and the commentary on Article 7 in the OECD Model Tax Convention on Income and on Capital . Currently, the Steering Group on the OECD Transfer Pricing Guidelines is developing further guidelines on the application of the principles in the OECD Guidelines to PEs. This Ruling follows the guidance from the OECD except: (a) where special provisions in Australia's DTAs and domestic law require or permit Australia to take a different approach; and (b) where there is no agreement at the OECD on all details for the attribution of profits to a PE.

In considering the taxation of PEs, this Ruling takes the following approach: (a) The arm's length principle provides the economic foundation for taxation of PEs and the interpretation must be consistent with that principle as embodied in Australian law. The operation of the arm's length principle is explained in Taxation Rulings TR 94/14, TR 97/20 and TR 98/11 in relation to separate legal entities. (b) To the extent that this Ruling goes beyond topics covered in the major transfer pricing rulings released to date, it should provide a basis for a consistent treatment of these matters in the associated enterprises case. (c) The principles contained in this Ruling are applicable to all dealings where the taxpayer has a PE, either in Australia or overseas.

This Ruling does not discuss in detail whether a PE is in existence.

This Ruling applies to years commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling. [F3]

As there has been a progressive development of the approaches outlined in this Ruling and as these approaches are only intended as a guide, the fact that a taxpayer has not applied them is not critical provided the result is consistent with Australia's PE attribution rules. Having regard to the recommendations of the Ralph Committee [F4] , further developments (possibly including legislation) may be expected.

Below is a detailed contents list for this draft Ruling: Paragraph What this Ruling is about 1 Date of effect 7 Detailed contents list 9 Your comments 10 Ruling and explanation 1 . 1 Chapter 1: The nature of PEs and principles of taxation 1.1 Step 1 . 1 : Identify the economically significant activities carried out by the enterprise in the relevant countries . 1.6 Step 1 . 2 : Postulate the existence of the relevant PE . 1.11 Step 1 . 3 : Identify where the economically significant activities are carried out and allocate these where appropriate to the postulated PE . 1.13 Step 1 . 4 : Identify the scope , type , value and timing of the international dealings arising between the PE and the other parts of the enterprise . 1.22 Step 1 . 5 : Based on a factual understanding of the postulated PE identify the most appropriate structural analogue ( s ) to use as a basis for a comparability analysis and in determining taxable income . 1.23 Chapter 2: The role and structure of Australia's PE attribution rules 2.1 Attribution rules under Income Tax Assessment Act (' ITAA' ) 2.1 Income Tax Assessment Act 2.4 Allocation of income and expenditure 2.7 Attribution rules under Double Tax Agreements 2.16 The ATO approach 2.19 Alternative approach adopted by some countries 2.22 Chapter 3: The interaction between tax rules that affect PEs 3.1 Relationship of subsection 136AE ( 4 ) and section 136AD 3.1 Relationship of subsection 136AE ( 4 ) and the rest of Income Tax Assessment Act 3.7 Relationship of subsection 136AE ( 4 ) and the business profits article of DTAs 3.10 Business profits and associated enterprises provisions of treaties 3.17 Relationship between attribution rules under the business profits article and subsection 136AE ( 4 ) 3.22 Relationship with other provisions of the ITAA 3.24 Chapter 4: Concepts and interpretation of PE attribution rules 4.1 Tax result 4.1 ITAA 4.1 DTAs 4.5 Mandatory or discretionary application 4.6 ITAA 4.6 DTAs 4.8 Types of taxpayers 4.9 ITAA 4.9 DTAs 4.11 Residence 4.16 ITAA 4.16 DTAs 4.19 Permanent Establishment 4.22 ITAA 4.24 DTAs 4.26 Attribution 4.29 ITAA 4.29 DTAs 4.36 Source of income and allocation of expenditure 4.41 ITAA 4.41 DTAs 4.44 Income and profits 4.46 ITAA 4.47 DTAs 4.51 Expenditure 4.56 ITAA 4.56 DTAs 4.59 Paragraph 3 4.59 Only actual deductions allowed 4.62 Capital ( interest free funding ) 4.67 ITAA 4.68 DTAs 4.70 Losses 4.71 ITAA 4.71 DTAs 4.72 Exempt Income 4.77 ITAA 4.77 DTAs 4.79 Duration of the PE 4.80 ITAA 4.81 DTAs 4.83 Research and development ( 'R & D' ) 4.85 Intermittent PEs 4.88 Example 4.90 Special treaty rules 4.94 Chapter 5: Methodologies 5.1 Introduction 5.1 Segmentation - Accounting practice and taxation 5.6 A Structured Process for Modelling Attribution Issues 5.18 Step 1 . 1 : Identify the economically significant activities carried on by the entity 5.20 Step 1 . 2 : Postulate the existence of one or more permanent establishments - do they pass the threshold test ? 5.22 Step 1 . 3 : Identify the activities where the PE plays a role - directly or indirectly 5.23 Step 1 . 4 : Identify the scope , type , value and timing of the dealings of the PE 5.24 Step 1 . 5 : Determine the character and structure of the PE business 5.25 Step 2: Select the most appropriate methodology for attribution purposes 5.26 Step 3: Apply the most appropriate methodology and determine the arm's length outcome 5.28 Step 4 : Implement support process and install review process 5.29 Documentation 5.29 Examples 5.35 Example 1 - Functional Analysis - Installation Project 5.35 Example 2 - Calculating Segment Profits - Language School with foreign PE 5.49 Example 3 - Use of accepted transfer pricing methodologies to allocate income and expenditure to PEs 5.60 Chapter 6: Application 6.1 Introduction 6.1 Trading stock 6.8 Asset allocations and capital allowances 6.20 Depreciation under Australian Law 6.25 Services 6.30 Financial dealings and funding 6.38 Enterprises in General 6.38 Financial Institutions 6.40 Capital allocation for multinational banks 6.44 Example - Capital allocation to bank branch 6.48 Interbranch lending 6.52 Global Trading 6.56 Example - Australian bank with foreign branches 6.56 Deemed PEs 6.66

If you wish to comment on this draft Ruling, please send your comments promptly by 26 January 2000 to Comments by Date: 26 January 2000 Contact officer details have been removed following publication of the final ruling.